WASHINGTON (Reuters) - Personal income tumbled unexpectedly in July and inflation-adjusted spending shrank as government economic stimulus waned, but consumer spirits rose this month, a hint the economy may muddle through its woes.

Personal income fell 0.7 percent in July, the sharpest decline since a 2.3 percent plunge in August 2005, when Hurricane Katrina hit, the Commerce Department said on Friday. Analysts were expecting income to hold steady.

At the same time, a big jump in prices pushed inflation to a 17-year high, eroding what little spending power consumers had. Consumer spending, which accounts for about two-thirds of economic activity, rose 0.2 percent as expected, the slimmest gain since February, and inflation-adjusted spending fell by 0.4 percent, the biggest drop since June 2004 and the second straight monthly decline.

Consumer confidence hits its highest in five months in August, however, posting an unexpectedly large recovery from depressed levels with the help of moderating energy prices.

The Reuters/University of Michigan Surveys of Consumers said its final index of confidence for August rose to 63.0, its highest since March, from 61.2 in July.

"Consumers are certainly worried about the job and housing markets but lower gasoline prices have given them some tangible relief and we are seeing that relief expressed in the various consumer confidence figures," said Lynn Reaser, chief economist at Bank of America Capital Management in Boston.

The unexpectedly weak income and spending data combined with a jump in oil prices and disappointing earnings to drive stock prices down. In late morning, the blue chip Dow Jones industrial average was off more than 1 percent.

Prices for U.S. government bonds, which react negatively to inflation, moved lower, while the dollar held steady versus the euro but slipped against the yen.